Sovereign Debt Markets

Market sentiment deteriorated in early November due to a perceived lack of progress
by European officials in dealing with the debt crisis. Political instability
in several euro area countries also contributed to the uncertainty, with new
governments being formed in Greece and Italy.

Financial market conditions have improved in the new year. In addition to generally
better-than-expected US economic data, sentiment was bolstered by large-scale
lending to banks by the European Central Bank (ECB) (see section on ‘Central
Bank Policy’). This has improved liquidity in the European banking system
and reduced the near-term risk of bank failures. Investor sentiment, however,
remains vulnerable to developments in the European sovereign debt crisis.

Over the past few months, European policymakers have announced several initiatives
to deal with the crisis. These included a ‘fiscal compact’, agreed
to by all European Union (EU) countries except the United Kingdom and the Czech
Republic, which will see enforceable fiscal rules and penalties written into
a new treaty. The new treaty will be signed in March and will come into force
once it has been ratified by 12 euro area countries.

EU governments also pledged a number of measures related to financial bail-out resources:

the permanent European Stability Mechanism (ESM) will be operational from July
2012, one year ahead of schedule, and its combined lending capacity with the
existing European Financial Stability Facility (EFSF) of €500 billion
will be reassessed in March this year;

governments will accelerate payments of capital into the ESM;

changes to the ESM will be able to be made by a qualified majority of countries,
rather than by unanimity;

leveraging of the current EFSF will be implemented rapidly; and

private sector involvement in bail-outs, like that for Greece, will not be mandatory
in future assistance packages for other countries.

Spreads on sovereign bonds issued by a broad range of euro area countries widened
sharply in November, with those for Austria, Belgium, France, Italy and Spain
reaching new euro-era highs (Graph 2.1).
Reflecting the improvement in sentiment since then, euro area government bond
yields have fallen from their recent peaks (Graph 2.2).
Perceptions of the risk of a near-term euro area break-up and/or banking crisis
have receded.

The deterioration in the outlook for euro area economies prompted Standard &
Poor's (S&P) and Fitch to place the ratings of many euro area sovereigns
on negative credit watch in December. S&P subsequently downgraded the credit
ratings of nine euro area sovereigns in January: Italy, Spain, Portugal and
Cyprus by two notches; and Austria, France, Malta, Slovenia and the Slovak
Republic by one notch. As a result, France and Austria lost their AAA ratings
although this had little market impact. S&P also downgraded the EFSF's
rating to AA+ (although it is still rated AAA by Fitch and Moody's).
Fitch downgraded five euro area sovereigns in late January but reaffirmed France's
AAA credit rating.

The agreement on the restructuring of private sector holdings of Greek sovereign
debt appears to be reaching a conclusion with a loss in net present value terms
of approximately 70 per cent in prospect. The latest EU/IMF disbursements to
Greece under the initial assistance package were approved in December despite
substantial slippage by Greece in meeting its targets under the program: €73
billion of the €110 billion first assistance package has now been disbursed.
Greece is fully funded until 20 March when a €14.4 billion bond matures.
The EU and IMF have also approved the latest disbursements to Ireland and Portugal.
Nonetheless, yields on Portuguese government debt increased to euro area highs
in recent weeks due to concerns about the possibility of a similar outcome
to Greece.

Yields on longer-term Italian government bonds remain relatively high despite falling
after the new technocrat government passed a number of fiscal reforms. Investors
remain nervous about the large volume of Italian government debt maturing this
year (equivalent to around 20 per cent of GDP), particularly over the next
few months (Graph 2.3).
Yields on Spanish government bonds are well below their November peak, in part
due to the government announcing additional budgetary measures and pledging
to legislate fiscal rules to enforce budget discipline on both central and
regional governments. The fall in yields was despite Spain's 2011 budget
deficit being equivalent to at least 8 per cent of GDP compared with the 6
per cent government target. Spain has completed around one-quarter of its anticipated
2012 bond issuance. Belgium's sovereign finances have come under scrutiny
in recent months, in part because of its substantial banking sector support.
Belgium formed a new government in early December, having had a caretaker government
since June 2010.

The improvement in investor sentiment has seen the ECB purchase only a small amount
of sovereign debt under the Securities Markets Program in recent weeks (Graph 2.4).

Government bond yields in the major advanced economies have remained at low levels
due to strong demand for debt issued by the US Government and those sovereigns
perceived to have solid AAA ratings. Yields on 10-year US, UK and German government
bonds remained around or below 2 per cent, with UK yields falling to a historical
low (Graph 2.5).
Secondary market yields on very short-term German government securities have
been negative in recent months, resulting in the format of German government
debt auctions being changed, allowing investors to effectively bid at negative
yields. In addition, yields in short-term secured funding markets fell to very
low levels, reflecting the dearth of available high-quality government securities
to be used as collateral to raise funding.

In the United States, the Joint Select Committee on Deficit Reduction (the ‘Super
Committee’), formed after the debt-ceiling impasse in August, failed
to reach an agreement on reducing the US budget deficit. Unless a new agreement
is reached, automatic budget cuts of US$1.2 trillion will be implemented from
2013. These developments have not had any noticeable impact on US government
bond yields.

Spreads on US dollar-denominated debt issued by emerging market sovereigns widened
sharply from August last year as global risk appetite waned (Graph 2.6).
Spreads on emerging European sovereign debt widened particularly sharply due
to fears that the euro area debt crisis could spill over to the region, including
through banking channels. The rise in Hungarian yields has been particularly
stark. In contrast, yields on Indonesian government bonds declined after Moody's
upgraded Indonesia's credit rating to investment grade, citing a more favourable
assessment of the country's economic strength.

Central Bank Policy

A number of central banks have eased monetary policy in recent months as the outlook
for global growth has weakened (Table 2.1).
Among these, the ECB lowered its policy rate target by a cumulative 50 basis
points. In addition, the People's Bank of China and Reserve Bank of India
lowered banks' reserve requirement ratios by 50 basis points; these were
the first decreases by these banks in around three years.

The ECB has significantly increased its lending to banks and its purchases of sovereign
debt since the European sovereign debt crisis escalated in mid 2011. Since
June, the ECB's balance sheet has expanded by around one-third to €2.7
trillion. The ECB provided €489 billion of 3-year loans to banks at its
policy rate in December, of which around €190 billion was new lending
(the difference was loans maturing or rolled into 3-year loans). Lending through
the Bank of Italy increased particularly sharply over December, with significant
increases also recorded by the national central banks of Belgium, France, Germany
and Spain (Graph 2.7).
The ECB's actions have allowed banks to secure long-term financing at a
time when market based funding has become increasingly difficult to obtain.
The ECB will provide additional 3-year loans at the end of February.

The ECB also announced a broadening of the range of eligible collateral for its market
operations to further support banks' access to liquidity. The ECB has lowered
the rating threshold for certain asset-backed securities and, as a temporary
measure, will allow national central banks to accept certain bank loans as
collateral. The ECB also reduced banks' required reserves ratio from 2 per cent
to 1 per cent, freeing up additional liquidity.

In response to the increased cost of obtaining US dollar funding for non-US banks,
in early December the major central banks announced a decrease in the cost
of accessing US dollars under the swap facilities with the Federal Reserve.
The margin over the US dollar overnight indexed swap rate fell from 100 basis
points to 50 basis points. Subsequently, recourse to the facilities increased
sharply to around US$110 billion but remains relatively modest compared with
peak usage at the height of the financial crisis (Graph 2.8).
To some extent this reflects European banks having scaled back their US dollar
assets and related funding needs over the past few years.

The US Federal Reserve has purchased around US$175 billion of longer-term US Treasuries
as part of a US$400 billion program to extend the average maturity of its bond
holdings, due to be completed by end June. The Fed currently holds around 30
per cent of outstanding longer-term US Treasuries and this share is expected
to rise to around 40 per cent at the completion of the program. The Fed also
resumed sales of mortgage-backed securities that its investment vehicle, Maiden
Lane II, had acquired in December 2008 as part of AIG's bail out.

The Fed stated after its policy meeting in late January that the federal funds rate
target was now likely to remain at exceptionally low levels at least until
late 2014. As part of a number of changes to its policy communications, the
Fed announced a long-run goal of 2 per cent for inflation (based on the personal
consumption expenditure price index) and has commenced quarterly publication
(without identification) of each meeting participant's expectations of
the policy rate for the next few years and in the longer run.

The Bank of England (BoE) has completed the expansion of its Asset Purchase Facility.
The BoE has purchased £75 billion of gilts since October 2011, bringing
total asset purchases under the facility to £275 billion.

Financial Policy and Regulation

The European Banking Authority (EBA) released its EU bank recapitalisation plan in
early December. The EBA requires banks to have core Tier 1 capital ratios of
9 per cent by 30 June. After allowing for any losses on holdings of sovereign
debt, the 65 participating banks would require about €115 billion in additional
capital to meet their required capital ratios. Many banks, however, are expected
to meet at least part of their capital ratio targets by shrinking their balance
sheets via asset sales and/or restricting lending, particularly outside of
the EU. Indeed, a number of banks have recently sold, or announced plans to
sell, significant banking operations outside of their home country.

The Obama Administration announced changes to the Home Affordable Modification Program
(HAMP) to expand eligibility for mortgage refinancing, including to the owners
of rental properties. Incentives for eligible participants (which will now
include Fannie Mae and Freddie Mac) to modify loans will also be increased,
including a boost in incentive payments from 18 per cent to 63 per cent of
principal reduction. Furthermore, HAMP will be extended to December 2013.

In the United Kingdom, the government accepted the vast majority of the recommendations
of the ‘Vickers Report’ by the Independent Commission on Banking.
Recommendations included increasing capital requirements and the ‘ring-fencing’
of commercial banking activities from wholesale banking groups. Subsequently,
the Royal Bank of Scotland (RBS) announced details of its plans to reduce and
restructure its wholesale operations. A notable concession will apply, however,
to HSBC and Standard Chartered, which will have to meet the higher capital
requirements only for assets in the United Kingdom rather than globally.

The UK Government also announced its sale of Northern Rock. Virgin Money is acquiring
the bank's retail and wholesale deposit businesses, along with its performing
mortgage book, for at least £900 million. The government had nationalised
the bank for £1.4 billion in 2008 and retains the bank's distressed
assets in a ‘bad bank’ to wind down over time. This bad bank has
been profitable and paid back around £2.1 billion of its £22.8
billion government loan by June 2011. The UK Treasury still holds majority
stakes in RBS and Lloyds.

French President Sarkozy unveiled plans to introduce a financial transactions tax
in France starting in August, irrespective of the outcome of the current EU
initiative to introduce such a tax. It is expected to generate around €1
billion a year and will reportedly apply to certain credit default swap and
equity transactions. However, unlike the EU's proposal, bond purchases
will be exempt.

Credit Markets

Conditions in credit markets have improved in recent months but remain strained for
European banks. The relative cost of short-term unsecured borrowing in euros
has fallen modestly since late December as market sentiment and liquidity have
improved following the ECB's large 3-year lending operation (see section
on ‘Central Bank Policy’;
Graph 2.9).
Euro area bank bond issuance moderated in the second half of 2011, and was
very low in December, as yields rose sharply and markets closed to some borrowers
(Graph 2.10).
While covered bond issuance remained relatively solid, unsecured issuance declined
to low levels. Issuance increased in January with the improvement in sentiment
but also reflecting the need to refinance sizeable bond maturities in the early
months of this year. Looking ahead, declining economic activity in Europe,
balance sheet contraction by euro area banks, and access to 3-year ECB funding
is likely to reduce euro area banks' debt funding needs.

The cost of swapping euros (and yen) into US dollars in the foreign exchange market
also declined after the US Federal Reserve reduced the cost to banks of borrowing
US dollars via its swap facilities with other central banks (see section on
‘Central Bank Policy’;
Graph 2.11).
Some European banks have continued to scale back their need for US dollars
by selling US dollar assets or reducing US dollar lending. The latter includes
the provision of trade and commodity finance, which is typically denominated
in US dollars. At the same time, US money market funds have continued to reduce
their exposures to euro area, particularly French, banks (Graph 2.12).

US banks' bond issuance picked up in January after being relatively subdued over
the previous six months. Yields on financial and non-financial bonds in the
United States and the euro area have generally fallen in net terms over the
past few months (Graph 2.13).
Issuance by US non-financial corporates has remained solid but in 2011 was
lower than in the previous year (Graph 2.14).
In part, this has reflected their strong internal funding growth and significant
holdings of cash and other liquid assets.

Equities

Global equity prices fell by 9 per cent over 2011 and double-digit declines were
common across countries. The US equity market was a notable exception, reflecting
relatively strong corporate earnings and better-than-expected economic data
(Table 2.2,
Graph 2.15).
Euro area equity prices fell by 18 per cent with financial share prices particularly
weak (see below). Chinese equity prices fell by 22 per cent over the year,
partly reflecting concerns about the effect of policy tightening and the deteriorating
global growth outlook on the domestic economy.

Equity price indices generally increased over January 2012, supported by the better
recent US economic data and the modest improvement in the European debt situation.
This occurred despite relatively disappointing US corporate earnings reports
for the December quarter. Share price volatility implied by options declined
to below long-run averages.

Banking sector share prices significantly underperformed over 2011, particularly
in Europe where the market value of some large banks more than halved (Graph 2.16).
The European debt crisis and concerns surrounding euro area banks' need
to raise capital to meet regulatory requirements has weighed on their share
prices. Moreover, several European and US banks' ratings were downgraded
or placed on review for downgrade, including a number of large banks following
S&P's shift to new bank rating criteria. Recently, however, banks'
share prices have increased in line with the improvement in investor sentiment.

Large US bank earnings for the December quarter were mixed, with weak trading and
investment banking revenues weighing on earnings. For 2011 as a whole, aggregate
profit for the six largest US banks was about US$50 billion, marginally higher
than in 2010 (Graph 2.17).
Profits were boosted by a US$45 billion fall in loan-loss provisions. Return
on common equity remained at less than half pre-crisis rates.

Emerging market equity prices in aggregate underperformed those in developed markets
over 2011, reaching their lowest point since mid 2009 (Graph 2.18).
In recent months, share prices in most of emerging Asia have risen strongly
but Chinese share prices continued to underperform due to concerns about slower
growth. In Latin America, equity prices rose particularly sharply in Brazil,
in part supported by monetary policy easing.

Hedge Funds

Global hedge funds recorded an average loss on investments of 5 per cent over the
year to December (Graph 2.19).
While hedge funds significantly underperformed equities over the December quarter,
they provided similar total returns (including dividends) for the year as a
whole. Funds under management edged up to US$2.0 trillion, with positive quarterly
returns more than offsetting a very small withdrawal of investor contributions,
the first net quarterly withdrawal of capital since the December quarter 2009.

Foreign Exchange

The European sovereign debt crisis has continued to drive developments in foreign
exchange markets in recent months, although the reduction in news flow saw
volatility in foreign exchange markets ease somewhat.

The euro has depreciated against most currencies since late October, having previously
been relatively resilient to concerns about the prospects for a near-term resolution
to the European debt crisis. This depreciation has generally been more pronounced
against non-European currencies, as other European currencies have typically
been affected by concerns about possible spillovers from the euro area. Since
mid 2011, the euro has depreciated by between 10 and 20 per cent against the
US dollar and the Japanese yen, but by 4–8 per cent against the main
Scandinavian currencies and the UK pound (Graph 2.20).
In contrast, since early September, the Swiss franc has moved little against
the euro as it continues to operate under a ceiling imposed by the Swiss National
Bank against the euro. Overall, the euro has depreciated by 8 per cent on a
trade-weighted basis since mid last year, to be around its long-run average.

As the euro continued to shift lower in December and early January, previously close
correlations between developments in the euro and other assets weakened markedly.
In particular, the MSCI World and Euro STOXX equity indices have both risen
strongly over the past three months, despite the euro's broad-based depreciation.

The US dollar has appreciated particularly strongly against the euro, but has depreciated
against most other currencies since late October (Table 2.3,
Graph 2.21).
Over the past year, the US dollar is unchanged on a trade-weighted basis and
remains well below its long-run average.

The Japanese yen has depreciated modestly against the US dollar from its recent
highs reached in late October/early November, following the Japanese authorities
intervening in the foreign exchange market by buying up to US$120 billion to
weaken the yen. Overall, the yen is unchanged against the US dollar over the
past six months, and has generally traded in a very narrow range of 76–78
yen per US dollar throughout much of this period. However, the yen has appreciated
by 6 per cent against the euro since late October, reaching an 11-year high
in January. Reflecting this, Japan's nominal trade-weighted index has returned
to historically high levels, though it remains only slightly above its long-run
average in real terms (Graph 2.22).

The Chinese renminbi appears to have come under some downward pressure in the last
two months of 2011, reflecting weaker global risk sentiment and some concerns
about the outlook for the Chinese economy. This was seen in the renminbi trading
close to the bottom of the official trading band throughout December. Also
consistent with this, the Chinese authorities reported declines in their foreign
exchange reserve holdings in November and December, resulting in the first
quarterly decline in China's reserves since the June quarter 1998 (Table 2.4).
Although valuation effects will have contributed to this fall, it seems likely
that the Chinese authorities sold foreign exchange to support the renminbi
during the quarter. Nevertheless, the authorities have appreciated the currency,
albeit only slightly, against the US dollar since the previous Statement,
taking the cumulative appreciation over 2011 to around 4½ per cent
(Graph 2.23).

The apparent downward pressure on the renminbi in late 2011 was also reflected
in the offshore (floating) renminbi exchange rate, which traded at a small
discount to the onshore rate throughout this period, and in the non-deliverable
forward market, which had been pricing in a small expected depreciation of
the onshore renminbi exchange rate over the next year. However, in line with
generally improved risk appetite, the offshore rate is now trading at a small
premium to the onshore rate, and the non-deliverable forward market is again
pricing in a small expected appreciation of the renminbi over the next year.

After depreciating further in the last few months of 2011, other emerging market
currencies have appreciated in 2012 to date (Graph 2.24).
Emerging European currencies remain relatively weak, reflecting ongoing concerns
about spillover effects from the euro area debt crisis. The Turkish lira reached
its lowest level against the US dollar in late December since it floated in
2001, prompting the Central Bank of Turkey to intervene to support the currency,
with the lira since appreciating by around 10 per cent from this low. Consistent
with this reported intervention, Turkey's foreign currency reserves fell
over the quarter (Table 2.4).

Emerging Asian currencies have also appreciated since the start of the year,
retracing the depreciations seen in late 2011 (Graph 2.25).
The Indian rupee depreciated particularly sharply in the latter part of 2011,
in response to the deteriorating growth outlook for the Indian economy and
concerns about India's reliance on external funding. The rupee troughed
in mid December and has since recovered around one-half of its decline, supported
by the more general improvement in risk sentiment outside of Europe and sales
of foreign exchange by the Indian authorities in order to support the rupee.

Australian Dollar

The Australian dollar has traded in a wide range over recent months, but has
appreciated significantly since mid December (Table 2.5).
In particular, the Australian dollar has appreciated strongly against the euro,
reaching its highest level in early February since the inception of the euro
in 1999 and, based on historical movements in the Deutsche mark prior to the
euro's introduction, its highest level against a representative European
currency since early 1989 (Graph 2.26).
This contrasts with much of 2011, when movements in the Australian dollar tended
to be closely correlated with developments in the euro. The Australian dollar
also reached its highest level since February 1985 against the British pound.

In trade-weighted terms, the Australian dollar is around its highest level since
mid last year, notwithstanding a decline in the terms of trade, and has appreciated
by around 5 per cent over the past year (Table 2.5).
In line with developments in other currencies, intraday volatility in the Australian
dollar has eased to levels seen in early 2011.

Capital Flows

Consistent with the trend of the past two years, net capital inflows in the
September quarter 2011 were directed towards the public sector, reflecting
strong foreign purchases of government securities. In contrast, there was a
large net outflow of capital from the private sector, predominantly reflecting
financial derivative outflows (including margin or final payments made on derivative
positions that had acquired a negative market value for the Australian holder)
and a reduction in Australian banks' overseas borrowing (Graph 2.27).
These net debt outflows from the Australian banking sector were partly offset
by net equity inflows to Australian private non-financial corporations, reflecting
continued strong foreign investment in the Australian mining sector and the
repatriation of overseas equity investments by Australian firms.